2/21/14 – Minimum Wages, Corporate Taxes, and Profit Margins

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 21, 2014 9:29:02 AM

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As I’ve written many times before, profit margins are at or close to all-time highs. The reasons are many, but among the most significant are low wage growth (which has kept labor costs down), low effective (not face!) tax rates, and low interest rates. The argument that current equity valuations are reasonable implicitly assumes that these conditions will remain constant for the medium-term future, and I have had a problem with that.

So far, of course, I’ve been wrong. But I’m okay with it, because I expect over time to be right, and the trends are starting to indicate that might be happening. This week alone, several events have suggested these factors may become less favorable to business profits.

The first event is the release of the minutes of the last Federal Reserve meeting, where a couple of members actually started talking about raising rates. This is a big deal, as it’s the first time in years that raising rates (as opposed to, say, reducing stimulus) has been seriously proposed. I’ve noted before that the expectation for continued easy policy by the Fed is very likely too optimistic, and this shows that some members are thinking the same thing. Low interest rates aren’t going away quickly, but they are on track to start going away faster than the market thinks.

The second item is the potential for increases in the minimum wage, and by extension, all wages. There are arguments on both sides over whether this would be a good thing, but the social argument is starting to dominate. The most recent sign of this is Gap’s decision to raise its own minimum to $10 per hour. Along with several state decisions to increase minimums, including California and New York, this has prompted a number of analyses that compare the economic benefits and costs of such an increase—the most notable being the CBO report I discussed the other day. Two of the largest states will now have higher labor costs, and major companies are at least thinking about it. Labor costs are unlikely to remain as subdued as they have been, any way you look at it, and higher labor costs will directly hit bottom-line profits.

The third piece today is Obama’s decision to focus on making it harder for corporations to avoid taxes by structuring their businesses through international tax havens. Politically, it’s hard to see the downside of this, and the Republicans may be less willing than usual to fight it with the midterm elections coming up. Economically, it’s not as clear-cut as a higher/lower tax decision usually is, which makes it harder to oppose. Again, this won’t necessarily pass, but the clear trend is against lower taxes. At a minimum, it’s a signal that this tailwind for business is fading.

We are passing through a period that has actually been very favorable for U.S. business from an economic, tax, and regulatory perspective. Historically, this has been unusual, and as investors, we need to keep an eye out for signals it may change. I would argue that those are exactly the signals we are now seeing.

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Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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